Foreign Interest: A Closer Look at the International Bond Markets

    by Annette Thau

    Foreign Interest: A Closer Look At The International Bond Markets Splash image

    In 2002 and 2003, total returns of funds investing in various sectors of the international bond market have ranged from very good to stellar: between 10% and 30% for each year (according to data supplied by Lipper Analytical). These returns placed these funds among the best performing of all mutual funds during those years.

    As always, after a sector of the market has had very good returns, the question facing investors is: Is there still a case to be made for investing in international bonds?

    If you have a large and fairly diversified investment portfolio, there is a case to be made for investing some percentage of that portfolio in international bonds. Briefly stated, it is this: Returns from international bonds do not correlate with those of U.S. bonds. Therefore, even though this is a risky class of investments, international bonds can lower the total risk of the portfolio.

    This case is strengthened by the fact that the value of bonds denominated in foreign currencies goes up when the dollar declines in value. As a result, investing in international bonds provides a hedge against a falling dollar. This case, however, stops well short of answering two important questions: What factors are behind the returns of the past two years? And how likely are these factors to continue?

    International bonds constitute a vast and very diverse market. Sectors in this market have the potential for outsize profits, but also for very significant losses.

    This article is the first of two about the international bond market. This article will provide an overview of the market: basic information about sectors, vocabulary, issuers, and historical background. A second article will discuss historical returns of various sectors, as well how to actually invest in international bonds.

    An Overview of the International Bond Market

    What is an international bond?

    The answer to this question may seem obvious, but it is not. The term “globalization” has been used to indicate that markets worldwide are becoming increasingly interdependent. The international bond market is a prime example of this interdependence.

    International bonds are issued by a broad variety of issuers. These include foreign governments; supranational entities such as the International Monetary Fund (IMF) and the World Bank; and multinational corporations from every corner of the globe.

    But, from the point of view of a U.S. investor, the first surprise is that international bonds are not all denominated in foreign currencies. Because the U.S. bond market is the largest, most liquid bond market in the world, many foreign issuers issue bonds denominated in U.S. dollars.

    On the other hand, many U.S. multinational firms issue bonds denominated in such currencies as the euro or the yen.

    There are a number of reasons why U.S. corporations issue bonds abroad. One might be to obtain more favorable financing—that is, to borrow at lower interest cost. Another, particularly for multinationals with plants abroad, might be to lay off some currency risk. This intermingling of issuers and currencies has resulted in a somewhat confusing terminology (see box above).

    However, from the standpoint of any U.S.-based investor, two critical distinctions stand out.

    Credit Quality
    The broadest distinction in the international bond market concerns credit quality: At one extreme are bonds with very strong credit characteristics. Those would include, for example, sovereign bonds issued by foreign governments of unimpeachable credit quality such as Japan, France, the UK, or the Netherlands; supranational agencies such as the IMF or the World Bank; or certain foreign multinational corporations with international reputations and strong balance sheets.

    At the other extreme are the bonds of so-called emerging markets. Emerging markets are defined in a variety of ways, but the most accepted definitions are based on a country’s gross domestic product or per capita income. Emerging market countries, in a nutshell, are very poor. Bonds issued by emerging market governments or by corporations located in emerging markets should be viewed by U.S. investors as a sub-sector of the market for riskier “junk” bonds: potentially high return, but extremely volatile and high risk.

    Currency Denomination
    The second important distinction is whether the international bond is denominated in U.S. dollars or in a foreign currency.

    U.S.-dollar-denominated bonds may present U.S. investors with an opportunity to earn higher yields than would be available on U.S. bonds with comparable credit quality and maturity. The critical factor for U.S. investors is that, regardless of the issuer, bonds denominated in U.S. dollars tend to track U.S. interest rates. (The one exception to this is Brady bonds; see box on p. 14).

    But, any foreign-pay bond—that is, any bond denominated in a currency other than the U.S. dollar—faces an entirely different kind of risk, namely, currency risk. That risk exists whether the issuer has a strong or a weak credit rating. This risk will be discussed below in the section entitled Currency Risk.

    Credit Ratings of International Bonds

    The major rating agencies: Moody’s, Standard & Poor’s, and Fitch all rate foreign bonds. The largest segment of that market is bonds issued by foreign governments (sovereigns). The credit rating evaluates both the ability of the government to pay as well as its willingness to pay.

    It is not a given that a government that is able to pay its debts will always be willing to do it: Some defaults are rooted in a political situation where a government will simply decide to renege on its foreign debts.

    How frequently do foreign governments default on their bonds? The answer may surprise you. Between 1970 and 1996, a survey by Standard & Poor’s of the debt of 113 governments numbered 69 defaults on foreign currency debt. (Note that Standard & Poor’s counts any debt restructuring as a default.)

    For sovereign governments, Standard & Poor’s assigns separate ratings to debt denominated in the local currency and to debt denominated in a foreign currency. That is due to the fact that defaults are much more common on debt denominated in foreign currency than on debt denominated in the local currency.

    As is the case with the U.S. market, however, ratings change. For example, in 1996, Malaysia was rated AA+ and Thailand AAA. That was one year before the Asian crisis and ensuing defaults. Also, defaults did not cease in 1996: Argentina defaulted on its bonds two years ago, and its bonds continue to be in default.

    Components of Total Return

    Returns from international bonds derive from some of the same sources as returns from any bond issued in the U.S.

    • The first is interest income from coupons paid by the issuer.
    • The second is any appreciation or decline in the value of the bond.
    • There is one additional potential component that is unique to foreign-pay bonds: changes in the dollar value of principal due to changes in the value of the currency of the bond.
    Each of these will be discussed in turn.

    Interest Income, or Yield
    One of the prime reasons for investing in foreign markets is the opportunity to earn higher yields than those available in the U.S. market. The very high yields (between 15% and 20%) initially available in the bonds of emerging markets were one of the major reasons that market took off. Higher yields are such an important factor in determining whether or not to invest in international bonds that publications reporting on international markets often list, not actual yields, but the difference between the yield of a particular bond and U.S. Treasuries of comparable maturity (that difference is known as the “spread”).

    Note, however, that as interest rates in the U.S. have declined to record lows, interest rates available on foreign debt in all markets, both developed and undeveloped, have declined enormously.

    At the current time (as of April 4), yields on foreign bonds with high quality credits are only marginally higher (roughly 25 basis points) than those available on U.S. Treasuries of comparable maturities. More strikingly, however, the spread to U.S. Treasuries of bonds of emerging markets with considerably higher credit risk has also narrowed significantly.

    You might wonder: Are there any bonds available that have really high yields?

    The answer to that is yes. The bonds of Argentina, currently in default, have theoretical yields close to 50%. I call these theoretical because, since the bonds are in default, they are not paying interest. If you want to speculate on what they would be worth after a restructuring, bear in mind that all restructurings of defaulted bonds always involves a significant amount of debt reduction. That term means that a significant portion of the debt, as much as 50% or more, is simply written off.

    Price Changes
    This has been a major source of the outsize total returns of many international bonds, particularly those of emerging markets.

    Changes in the price of any bond can occur for a number of different reasons. One is upgrades or downgrades. In the U.S. bond market, changes in credit quality result in significant appreciation or declines in the prices of bonds primarily in the junk bond market (corporate bonds rated below investment grade). Similarly, in the market for international bonds, changes in credit quality result in significant price changes primarily in the bonds of emerging markets.

    A second factor affecting bond price is changes in interest rates. If interest rates decline, the price of a bond goes up. If interest rates rise, the price of a bond declines. All bonds are subject to interest rate risk, regardless of credit quality.

    Both of these factors have played a major role in the total return of bonds in the international market. Those gains have had the greatest impact in the emerging market sector. A large number of countries were upgraded. Bonds issued by the Russian government went from default to investment grade in just five years. Bonds of many countries that export oil or other commodities were also upgraded (Venezuela, Brazil, Nigeria, Kazakhstan), as were bonds of countries such as Poland, Hungary, Thailand, and Malaysia, based on expectations of a worldwide improving economy led by the U.S. Similarly, declines in interest rates occurred in all international markets, but were particularly large in the debt of emerging markets whose credit quality was upgraded.

    This should raise some red flags: Spreads to U.S. Treasuries, across all markets, are at historical lows. What will happen if interest rates rise in the U.S.? Bear in mind that this continues to be a very volatile market. For example, a few years ago, Argentina pegged its currency to the U.S. dollar and it was being hailed as a model of economic discipline. Yet Argentina defaulted on its debt two years ago, and its bonds are still in default.

       Learning the Language: Foreign Bond Terminology
    Here are some definitions of terms that are used in the international bond markets.

    “Domestic” bonds: Bonds issued within a foreign country in that country’s currency. Examples: Bonds issued in baht in Thailand, or bonds issued in pesos in Mexico. These bonds are issued, underwritten and traded under the regulations of the country of issue.

    Eurobonds: Issued simultaneously in a number of foreign markets, in a variety of currencies including euros, yen, etc. They are not registered with the SEC even if they are denominated in U.S. dollars, and U.S. investors are unable to participate in the primary market (that is, they cannot buy at issue), although they can buy these bonds in the secondary market (that is, once they start trading).

    Eurodollar bonds: Eurobonds denominated in U.S. dollars.

    “Foreign” bonds: Issued by a borrower located outside a country but intended primarily for local investors. Examples: Samurai bonds—bonds issued in Japan for Japanese investors by issuers located outside Japan; Bulldog bond—sterling-denominated bonds issued for consumption in the UK by non-British issuers; and Yankee bonds—U.S.-dollar-denominated bonds, registered with the SEC, issued and traded within the United States, but issued by non-U.S. issuers. Yankee bonds are issued primarily by governments whose credit rating is very high (for example Italy, the province of Ontario, the province of Quebec, Hydro Quebec, and the like).

    Foreign-Pay Bonds: For U.S. investors, any bond issued in a currency other than the U.S. dollar. Foreign-pay bonds are probably the first type of bond any individual investor thinks of when he thinks of the international bond market. At the present time, the primary trading market for foreign-pay bonds remains outside the U.S., in the country of origin of the bonds.

    Global bonds: A hybrid; may be issued and traded in the U.S. or offshore, in the euromarket. Most global bonds are denominated in U.S. dollars.

    Currency Risk
    For U.S.-based investors, international bond total returns are also affected by a risk unique to all foreign-pay bonds, namely currency risk.

    Another term for currency risk is exchange-rate risk. If you have traveled outside the United States, you have experienced a form of currency risk. You know that at different times, a dollar will buy a larger amount, or a smaller amount, of a foreign currency, and that will affect the cost of hotel rooms, restaurant meals, and so forth.

    In spite of the fact that the symptoms of impending currency changes are well-known, changes in the relative values of currencies are notoriously difficult to predict. This is particularly true for the currencies of emerging markets. Sudden, dramatic changes in currency values sometimes occur without any apparent warning. The impact of a currency crisis, such as the meltdown that occurred in Asia in late 1998, can be catastrophic. Virtually overnight, some bonds lost as much as 50% or more of their value.

    Exchange-rate risk, however, is not limited to emerging markets. Shifts in the value of the currencies of well-developed countries also occur, although generally in a more orderly fashion, over a longer period of time. Still, those changes can be major. For example, the dollar has declined by 40% against the euro within the last two years. Over the last decade, one dollar has purchased as many as 200 yen and as few as approximately 80.

    Over short holding periods (a year or less), fluctuations in the value of currency are often the most significant component of total return, dwarfing both interest income and changes in price resulting from interest rate movements. Remember that the price of a foreign-pay bond has to be converted into the foreign currency both at the time of purchase and at the time of sale. This creates risk at both ends of the transaction. And this can result in apparent anomalies. It is not unusual for a bond to have a positive return in the local currency, and a negative total return in dollar terms, or vice-versa.

    If you own foreign-pay bonds, do you want to see the dollar rise or decline against those foreign currencies? The answer is: You want to see the dollar decline against the foreign currency you are buying. That is because any cash flow of the foreign-pay bond has to be converted back into U.S. dollars. To illustrate: Suppose you purchased bonds denominated in euros. If the dollar goes up against the euro, when you convert any of the bond’s cash flows into U.S. dollars, you will receive fewer dollars because the dollar has become more expensive relative to the euro. Conversely, if the dollar has declined against the euro, euros will buy larger amounts of the now cheaper dollar. That is the reason that investing in foreign-pay bonds is considered a hedge against a declining dollar.

    During 2003, the decline of the U.S. dollar against major currencies such as the yen and euro was a major factor in the high total returns of bond funds investing in foreign-pay bonds. If the dollar continues to weaken, that would continue to boost total return of international bond funds.


    The international bond market offers opportunities for U.S. investors both to earn higher yields than might be available in the domestic market and to hedge against a declining dollar. Over the past decade, the highest returns in that market have been earned in the riskiest and most volatile sector of that market, namely, that of emerging market bonds. At present, this is still a market where direct purchase is primarily the domain of institutions. But this is an expanding market. Part two of this series will look at investment opportunities in this market for the individual investor: types of bond funds available, past returns, and the pros and cons of investing at the current time.

       Emerging Market Bonds
    Emerging market bonds constitute the riskiest, most volatile sector of the international bond market. But during the past five years, the returns of emerging market bonds have been extraordinary. According to Lipper Services, for the one-year period of 2003, emerging market bond funds averaged total returns of 30%. Over the past five years, emerging market bond funds averaged a compounded annual return of nearly 18%.

    A brief history of this sector will explain the factors behind the returns.

    Emerging market debt owes its success to the development and evolution of the market for Brady bonds.

    Brady bonds had their origin in the defaults of a number of Latin American countries. In 1982, Mexico declared a moratorium on debt payments. A number of other Latin American countries followed suit. This left several of the largest American banks holding about $100 billion of dollars of loans in default.

    “Brady” bonds are named after the former U.S. Treasury Secretary Nicholas Brady, who played a leading role in solving what had become a major international debt crisis. The Brady plan developed a number of structures that enabled the banks to swap the defaulted loans for bonds issued by the Latin American governments involved in the defaults. The basic formula called for a steep write-off of the loan amount and also stretched out repayment of the debt over a period of as much as 30 years. In return for this debt relief, the governments issuing the bonds agreed to implement a program of reforms to their economies. The entire program was developed jointly by the U.S. Treasury, the World Bank and the International Monetary Fund (the IMF). In order to attract American investors, the bonds were to be issued in U.S. dollars. Not surprisingly, they paid very high yields, between 15% and 25%.

    The initial Brady plan offered banks a variety of options for restructuring their loans, resulting in several different types of bonds. In addition, Brady bonds incorporated a number of attractive features, the most important of which was that the principal of many Brady bonds was collateralized with U.S. Treasury zeros, purchased at the time the Brady bonds were issued, in an amount sufficient to cover the principal value of the bonds. In the event of a default, the collateral would be paid not at the time of the default but on the original maturity date of the bonds.

    In spite of initial skepticism, and an enormous amount of volatility, the Brady bond program turned into one of the most remarkable success stories in international finance. During the late 1980s and the decade of the 1990s, a large and liquid market developed for trading these bonds. Initially, Brady bonds were purchased primarily by large institutional investors such as pension funds or hedge funds. Subsequently, the market expanded to include a wide variety of mutual funds: Initially, mutual funds specializing in emerging market bonds, but also, and less obviously, “high-yield” (junk) bond funds, and international stock funds, both “value” and “growth.”

    Moreover, while initially developed to solve the Latin American debt crisis, the Brady program was extended to emerging market governments in every region of the globe. The formula remained similar to the original Brady plan: In return for capital and debt forgiveness or debt relief, governments of underdeveloped countries agreed to economic reforms demanded by the IMF and by the World Bank. In addition, many of the structures adopted for Brady bonds were also extended to debt issued by new entrants in the emerging debt market.

    Changes Over the Past Five Years

    Over the past five years, the market for debt from all emerging markets has undergone what can only be considered a veritable sea change.

    Consider the following:

    • As interest rates declined in the U.S., and as demand grew for Brady bonds, yields collapsed. As a result, spreads to U.S. Treasuries are the narrowest on record, as low as 2% to 4% on much emerging market debt.

    • The Latin American countries initially involved in the Brady program were able to retire their Brady bonds well before the initial maturity dates

    • Initially, the entire Brady bond sector, along with all other markets considered “emerging,” was rated as junk. The sovereign debt of many of these countries has been upgraded. Mexico, for example, is now rated investment grade. Russian sovereign bonds went from default to investment grade within the space of five years.

    • Initially, the entire Brady bond sector—and indeed, the entire emerging market debt sector—experienced very sharp price moves, either up or down, as one unit. For example, the Asian debt crisis of 1998 sent bond prices plummeting in all emerging markets worldwide. This is no longer true. Increasingly, countries are viewed on a stand-alone basis.

    • This is a continually expanding market—new countries are constantly entering the market for emerging debt, and new investors are entering the market as well, including individual investors, mainly through mutual funds.
    But is this a case of the little guy investing at the top? What is the prospect that the outsize gains of the past few years will continue?

    Clearly, when they were initially issued, the high yields of Brady bonds were the largest component of total return. However, during the last five years, by far the largest component of total return was capital appreciation, attributable both to upgrades in credit quality, as well as to a collapse in yields. Looking forward, speculative opportunities will no doubt continue to arise. (Anyone care to buy some bonds from Argentina—currently in default—for example?)

    As you look at debt for the emerging market sector as a whole, at least for the near term, upside potential for capital appreciation would appear to be limited given current low yields as well as narrow spreads to U.S. Treasuries. Furthermore, any rise in interest rates in the U.S. would in all likelihood be accompanied by larger rises in the interest rates of bonds of emerging markets—and consequently larger losses.

    Annette Thau, Ph.D., is author of “The Bond Book: Everything Investors Need to Know About Treasuries, Municipals, GNMAs, Corporates, Zeros, Bond Funds, Money Market Funds, and More,” (copyright 2001, published by McGraw-Hill; $29.95). She has spoken to AAII chapters in different parts of the country about bonds and bond funds.

    Ms. Thau is a former municipal bond analyst for Chase Manhattan Bank. She also until recently was a visiting scholar at the Columbia University Graduate School of Business.

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